Your 401(k) Has A Pretty Fascinating Back Story

We tend to think of 401(k) plans as the bedrock of the retirement
savings system.

But these plans, named after a section in the Internal Revenue
Code, were actually developed more by accident than by design.
When lawmakers originally established the Revenue Act of 1978,
the goal was to limit executives at some companies from having
too much access to the perks of cash-deferred plans. (Why, you
ask? Since the 1950s, companies had been fighting with the
Internal Revenue Service to allow more money to be squirreled
away in such plans.)

The accidental birth of the 401(k) can be credited to Ted Benna.
In 1980, the benefits consultant used his interpretation of the
law to create a 401(k) plan for his own employer, The Johnson
Cos., that allowed full-time employees to fund accounts with
pre-tax dollars and matching employer contributions. Benna then
asked the Internal Revenue Service to change some proposed rules
under the law that ultimately led to the widespread adoption of
401(k) plans by employers in the early 1980s.

"I knew it was going to be big, but I was certainly not
anticipating that it would be the primary way people would be
accumulating money for retirement 30 plus years later," Benna,
now semi-retired and the president of the 401(k) Association,
told Workforce magazine.

The 401(k) Grows Up: A 30-Year Timeline

In the early 1980s, 401(k) plans were only available at a handful
of large companies, such as Johnson & Johnson. Today, some
94% of private employers offer them.

A 401(k) plan is a retirement account that you can only access
through an employer. You contribute a portion of your salary to
the plan, and if you choose to put that contribution in a
traditional 401(k), it isn’t taxed until you withdraw the money,
allowing your investments to grow over time without being taxed.
(Note: You will pay penalties if you take out the money before a
set retirement age, as defined by the plan.) And, as an added
bonus, many employers will match some of your contributions.

In its relatively short history -- just 30 years! -- 401(k) plans
have had many milestones:

1978: Congress passes the Revenue Act of 1978,
which includes a provision that allows employees to avoid being
taxed on a portion of income that they decide to receive as
deferred compensation, rather than direct pay. The provision
becomes Internal Revenue Code Sec. 401(k).

1982: Several companies—such as Johnson &
Johnson, PepsiCo and Honeywell -- begin to offer 401(k) plans to
their employees. By 1983, nearly half of all large employers
either offer a 401(k) plan or are considering offering one,
according to the Employee Benefit Research Institute.

1984: The Tax Reform Act of 1984 requires
“nondiscrimination” testing to prevent 401(k) plans from favoring
highly compensated employees over rank-and-file workers. At the
time, Congress was concerned that executives would take advantage
of 401(k) plans more than lower-paid employees.

1996: Assets in 401(k) plans surpass $1
trillion, with more than 30 million participants.

2001: The Economic Growth and Tax Relief
Reconciliation Act of 2001 provides for catch-up contributions
for participants 50 and older, as well as the creation of Roth
401(k)s, which let after-tax contributions grow tax-free.

51 million Americans have more than $3.5 trillion invested in
401(k) plans, which is more than double the $1.6 trillion in
assets held by the plans in 2002, according to the Investment
Company Institute.
Assets in 401(k) plans represent 18% of the $19.4 trillion U.S.
retirement market.
The average account balance in a 401(k) plan reached $80,900 in
the first quarter this year. According to Fidelity Investments, a
large 401(k) plan administrator, that’s up 75% from $46,200
during the market low in the first quarter of 2009.

Benna, who’s referred to as the "Father of the 401(k)," has
actually been critical of his creation as of late, noting that
there are too many investing options available today and that
their complexity has a negative impact on 401(k) plan
participants.
"This monster is out of control. We went to three options, then
to six, then to seven, then to 15 -- it is far beyond what most
participants were able to deal with," Benna told SmartMoney
magazine. "And I am not convinced we have added value by getting
more complicated."

The original 401(k) plan had only two investing options: a stock
fund and a fund that guaranteed a return similar to a money
market fund. The typical 401(k) now offers 19 funds.

Some employers have been working to simplify 401(k) plans by
limiting the number of funds on a plan’s investment menu, as well
as automatically enrolling workers into target-date funds, which
adjust a portfolio of stocks and bonds as a participant
approaches retirement to reduce risk. Today, nearly 70% of 401(k)
plans offer a target-date fund as a default option, with about
12% of 401(k) assets invested in such funds.

The 401(k) Effect: Did These Plans Kill Pensions?

As 401(k) plans have thrived, traditional pension plans have
declined. According to the Department of Labor, from 1980 to
2008, the proportion of private workers participating in
traditional pension plans fell from 38% to 20%.

For employers, 401(k) plans are a more enticing option because
they cost less than traditional pension plans, and they don’t
carry the same accounting liabilities and investment risks. Some
401(k) critics even say that workers would be better off in
traditional pensions.

"We know after 30 years of this 401(k) experiment that people do
worse in 401(k)s than they would have if their money was in a
traditional plan or if it was in a plain vanilla retirement
account," Teresa Ghilarducci, director of the Schwartz Center for
Economic Policy Analysis at The New School for Social Research,
told PBS’s Frontline in April.

But pensions were never as widely available as 401(k) plans.
"Even in the 'good old days' when 'everybody' supposedly had a
pension, the reality is that most workers in the private sector
did not," writes Nevin Adams of the Center for Research on
Retirement Income at the Employee Benefit Research Institute.
"Even among those who did work for an employer that offered a
pension, most in the private sector weren’t working long enough
with a single employer to accumulate the service levels you need
for a full pension."

As a result, notes Adams, most workers who have pensions still
rely on a combination of Social Security and personal savings, in
addition to pension income to fund their retirements... and the
number of 401(k) plans continues to grow.

How to Make the Most of Your 401(k)

Despite the growth of 401(k) plans, there’s an estimated $6.6
trillion deficit in what Americans currently have in savings
compared to what they will actually need in retirement, according
to an analysis by the Center for Retirement Research at Boston
College.

This shortfall should make maximizing retirement accounts, like a
401(k) plan, a priority. As of 2013, you can contribute up to
$17,500 into a 401(k) plan, and put in $5,500 more if you’re 50
or older.

If you’re not maxing out your 401(k), you should consider
boosting your contribution by 1% every six months. For most of
us, that’s about $20 to $50 per paycheck, which you probably
wouldn’t miss much. And since most employers will automatically
deduct a 401(k) contribution from your paycheck, it makes the
extra savings easier to stomach.

Your employer may also offer to help you save more: Some 95% of
401(k) plans provide matching contributions, and the average
company contribution is 2.5% of an employee’s pay. Matching
policies among 401(k) plans differ depending on the company, but
the most common is a dollar-for-dollar match of up to 6% of an
employee's pay.

The Investing Answer: Even if you have a good 401(k) plan, the
most important thing to do is to start saving more now because
it's hard to make up for lost time when it comes to building a
healthy retirement nest egg.

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